Advantages and Disadvantages of Bank Guarantee

Understanding Bank Guarantee

Bank guarantee is a written instrument issued by lending institutions to the beneficiary (to whom the guarantee is provided, generally seller) on behalf of the applicant (generally, buyer). As the name suggests, under it, the bank promises to pay a certain amount of money to the beneficiary in case there is a default by the applicant. It basically compensates the beneficiary (seller) if the applicant (buyer) fails to make payment for the same. The bank charges a fee from the applicant for undertaking such guarantee.

Bank guarantee has many pros as well as cons. Below paragraphs mention some of them.

Advantages of Bank Guarantee

Reduction of Financial Risk

The need for bank guarantees arose because of the increased defaults by the buyers. Sellers were not willing to supply goods to unknown buyers without having payments received. A sense of mistrust was present. Bank guarantees solved this issue by acting as an assurer to the seller, i.e. the beneficiary in our case. The sellers, after obtaining bank guarantees, are ready to supply goods. It brought down their financial risk to a substantially low level.

Increased Opportunities

By having bank guarantees with itself, a business can grasp opportunities in the market which were earlier not available to it. A public perception would be developed that a bank stands with a particular business. Having a bank as a partner is always a sign of the inherent strength and faith towards the business.

Small Fees

The fees charged by the banks are also very nominal. It ranges from about 0.5% – 1% of the amount guaranteed by the bank. Due to its nominal nature, the fees do not have a significant impact on the profits of the business.

No Need for Advance Payments

Advance payments to the sellers have become a thing of the past. It means that the buyer can defer his cash outflow to a later date. By deferring payments, the available funds can be utilized currently to fuel extra growth.

Increased Credibility

Banks exercise extensive credit monitoring. They have specialized staff and tools which can accurately assess the financial health of a business. Hence, the credibility of the entity enhances as it is backed by the banks. The banker’s trust would reflect that the performance of the business is great and that there is no risk of default.

Less Documentation

In bank guarantees, lesser documentation is required. Only the information about the concerned parties, the details about the transaction about which guarantee is sought, financials of the applicant are generally demanded by the banks. The level and extent of documentation may change depending on the lender’s policy and period of credit.

Disadvantages of Bank Guarantee

Strict Assessment by Banks

When the applicant approaches the bank, seeking bank guarantee, the bank makes an assessment of the applicant’s creditworthiness and also of his financial health. The bank makes an elaborate financial analysis of the applicant before issuing such guarantee. Sometimes, this process becomes quite complicated which ultimately leads to either obtaining no guarantee or causes hindrances in obtaining a guarantee.

Financial Considerations

Another demerit of bank guarantee is that it is not suitable for loss-making businesses. The banks even refrain from the entities which have low cash reserves, weak credit policy etc. Moreover, businesses which operate on a low margin of profit are hesitant of taking bank guarantees as their margins are not significant enough to absorb fees.

Collateral

Charging a certain fee for extending bank guarantees is sometimes not enough. Collateral may be demanded by the banks in the form of movable assets of the company. The banks would also like to cover themselves in case they had to make the payment to the beneficiary. Pledging collateral security with a bank would reduce the company’s strength to finance its working capital in future.

Conclusion

Bank guarantee has its own merits and demerits. Before applying for bank guarantee, a business must make a complete analysis of its financial situation and requirements. The decision of obtaining bank guarantee must be thoughtful keeping in mind the risks involved, the forecasted business performance as well as the stability of the business. The benefits of a bank guarantee like smooth domestic or international trade, expansion of operations, enhancement of creditworthiness etc should also be considered.

Last updated on : April 12th, 2018

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